You bought one of BB Co.’s 9% coupon bonds one year ago for $1020. These bonds make annual payments and mature six years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 10%. If the inflation rate was 4.2% over the past year, what would be your total real return on investment?
(5 marks)
The returns on XYZ Corp. over the last four years are 10%, 12%, 3%, and 9%.
(5 marks)
What is the historical average return over the last four years?
What is the variance of the returns over the last four years?
What is the standard deviation of the returns over the last four years?
(10 marks)
Suppose we have two assets, A and B. What correlation levels between the two assets will yield diversification benefits in terms of portfolio risk reduction?
At what correlation level will there be no diversification benefits in terms of portfolio risk reduction?
Will there be any diversification benefits in terms of portfolio risk reduction in the case when the correlation between the two assets’ returns is 1?
(15 marks)
The expected returns, return variances, and the correlation between the returns of four securities are shown below.
Security 
Expected Return 
Variance of Returns 
Correlation 




A 
B 
C 
D 
A 
0.17 
0.0169 
1.0 
0.4 
0.7 
0.2 
B 
0.13 
0.0361 

1.0 
0.6 
0.5 
C 
0.09 
0.0049 


1.0 
0.9 
D 
0.07 
0.0050 



1.0 
Determine the expected return and variance for a portfolio composed of 25% of security A and 75% of security B.
Determine the expected return and variance of a portfolio that contains 78% security A and 22% security B. Is this portfolio superior to that one in (a) above?
Calculate the expected return and variance of a portfolio that contains 60% security C and 40% security D.
If an investor were to select among the following three portfolios, which one would he or she prefer?
An equallyweighted portfolio of securities A, B, and C.
An equallyweighted portfolio of A, B, and D.
An equallyweighted portfolio of B, C, and D.
If a riskadverse investor desires to hold a portfolio of only two securities and expects a return of 11%, what would you advise the investor to do?
Use the following information to answer the questions below. (10 marks)
Security 
Return 
Standard Deviation 
Beta 
A 
15% 
8% 
1.2 
B 
12% 
14% 
0.9 
Which of A and B has the least total risk? The least systematic risk?
What is the value of systematic risk for a portfolio with 75% of the funds invested in A and 25% of the funds invested in B?
Calculate the risk free rate of return and the market risk premium
(i.e., R_{f} and R_{M} – R_{f}).
What is the portfolio expected return and the portfolio beta if you invest 30% in A, 30% in B, and 40% in the riskfree asset?
(For questions (d) and (e), assume the risk free rate of return is 5%.)
What is the portfolio expected return with 125% invested in A and the remainder in the riskfree asset via borrowing at the riskfree interest rate?
What is the beta of the portfolio created in part (e)?
Consider the following information on three stocks. (10 marks)


Rate of Return if State Occurs 

State of economy 
Probability of state of economy 
Stock A 
Stock B 
Stock C 
Boom 
0.5 
0.2 
0.35 
0.6 
Normal 
0.3 
0.15 
0.12 
0.05 
Bust 
0.2 
0.01 
0.25 
0.5 
If your portfolio is invested 40% each in A and C, and 20% in B, what is the portfolio expected return?
What is the variance of this portfolio?
What is the standard deviation of this portfolio?
If the expected TBill rate is 5%, what is the expected risk premium on the portfolio?
If the expected inflation rate is 2.50%, what are the approximate and exact expected real returns on the portfolio?
If the expected TBill rate is 5% and the expected inflation rate is 2.50%, what are the approximate and exact expected real risk premiums on the portfolio?
Briefly discuss the advantages and disadvantages of using the dividend growth model to estimate the cost of equity. (5 marks)
Mustard Patch Doll Company needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $100,000. It is estimated that the firm will generate, after tax, operating cash flow (OCF) of $22,000 per year for the next seven years. The firm is financed with 40% debt and 60% equity, both based on market values. The firm’s cost of equity is 16% and its pretax cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%, respectively. Assume the firm’s tax rate is 34% and ignore the effects of CCA depreciation. (10 marks)
What is the firm’s tax adjusted WACC?
Ignoring flotation costs, what is the NPV of the proposed project?
What is the weighted average flotation cost, f_{A}, for the firm?
What is the dollar flotation cost of the proposed financing?
After considering flotation costs, what is the NPV of the proposed project?
Photosynthesis, Inc. is considering a project that will result in initial aftertax cash savings of $2 million at the end of the first year, and these savings will grow at a rate of 6% per year indefinitely. The firm has a target debtequity ratio of 1.5, a cost of equity of 20%, and an aftertax cost of debt of 7%. The costsaving proposal is somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +10% to the cost of capital for such risky projects.
Under what circumstances should Photosynthesis take on the project? (10 marks)
ABC Co. has the following dividend payment history: (10 marks)
Year 
Dividend 
2003 
$1.00 
2004 
1.15 
2005 
1.25 
2006 
1.35 
2007 
1.45 
How many periods of growth are there in the information given?
What is the compound growth rate of dividends?
Calculate the yeartoyear growth rates in dividends.
What is the average yeartoyear dividend growth rate?
Assume a retention ratio of 0.45 and a historical return on equity (ROE) of 0.18. Using these two additional pieces of information, calculate an alternative estimate of dividend growth rate, g.
TUV Guy Inc. is proposing a rights offering. There are currently 240,000 shares outstanding at $80 each. There will be 60,000 new shares offered at $60 each.
(10 marks)
What is the new market value of the company?
How many rights are associated with one of the new shares?
What is the value of a right?
What is the exrights price per share?
Why might a company have a rights offering rather than a general cash offer?
WXYZ Co. has concluded that additional equity financing will be needed to expand operations, and that the needed funds will be best obtained through a rights offering. It has correctly determined that as a result of the rights offering, the share price will fall from $50 to $45 ($50 is the rightson price; $45 is the exrights price). The company is seeking $12.5 million in additional funds with a per share subscription price of $25.
How many shares are there currently, before the offering? (Assume that the increment to the market value of the equity equals the gross proceeds from the offering.)
(10 marks)
(10 marks)
In five sentences or less, briefly explain the M&M Proposition I with taxes. Ensure that you include the appropriate formula in your explanation.
What are the two implications of M&M Proposition I with taxes?
In five sentences or less, briefly explain the M&M Proposition II with taxes. Ensure that you include the appropriate formula in your explanation.
What are the two implications of M&M Proposition II with taxes?
Under what conditions of personal and corporate taxation will there be no gain from financial leverage? Explain using the formula
V_{L} = V_{U} + [1 – (1T_{C}) x (1T_{S})/(1T_{b})] x D
(5 marks)
VWX Corporation has an EBIT of $166,666.67, a corporate tax rate of 40%, debt of $500,000, and unlevered cost of capital of 20%. The cost of debt capital is 10%.
(10 marks)
What is the value of VWX’s equity?
What is the cost of equity capital for VWX?
What is the WACC?
Compare the WACC of VWX to the WACC of an unlevered firm. What is your conclusion? What principle have you proven in this case?
STU’s Disco Factory Inc. is financed solely by equity and it is considering issuing debt and using the proceeds to repurchase some of the outstanding shares at the current market price of $30. There are currently 200,000 shares outstanding. EBIT is expected to remain at $1.5 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8%, and the firm’s tax rate is 40%. Three alternative amounts of debt are being considered:
Amount of debt 
0 
$1,000,000 
$2,000,000 
Required return on equity 
15% 
15.5% 
16% 
Assume that all stock repurchases will be made at $30 per share. (15 marks)
Using the M&M Proposition I with taxes, calculate the value of the firm at each debt level.
What is the optimum amount of debt?
Show that, at the optimum capital structure, the firm also minimizes the WACC.
Show that, at the optimum capital structure, the firm also maximizes the price of the outstanding shares.
Explain homemade leverage and why it matters. (5 marks)
Positive NPV projects enhance shareholder wealth. However, in some cases the payment of dividends limits the number of positive NPV projects a firm can take. Why, then, shouldn’t shareholders prefer a residual dividend policy? (5 marks)
You own 1,000 shares of stock in ABC Corporation. You will receive a 60 cent per share dividend in one year. In two years, ABC will pay a liquidating dividend of $30 per share. The required return on ABC stock is 15%. What is the current share price of your stock (ignoring taxes)? If you would rather have equal dividends in each of the next two years, show how you can accomplish this by creating homemade dividends.
(Hint: Dividends will be in the form of an annuity.)
Suppose you want only $200 total in dividends the first year. What will your homemade dividend be in two years? (10 marks)
_{ }
Suppose we have two equally risky firms, Firm A and B. Firm B’s shares are currently worth $100, and they are expected to be worth $120 in one year. Personal dividend tax rate is 30%, and capital gains are exempt from taxes. (10 marks)
What is the aftertax return on Firm B?
If Firm A opts to pay a dividend of $20 per share in one year, what is the aftertax return on Firm A?
Given that dividends will reduce firm value proportionally, what is the share price of Firm A’s stock if it pays a dividend of $20 in one year?
Subject  Business 
Due By (Pacific Time)  03/31/2014 10:00 am 
Tutor  Rating 

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